Leverage ratio

Recommendation 7

Introduce a leverage ratio that acts as a backstop to authorised deposit-taking institutions’ risk-weighted capital positions.

Description

APRA should introduce a leverage ratio as a backstop requirement, providing a floor to ADIs’ risk-weighted capital requirements. This should be introduced as part of Australia’s adoption of the Basel framework and in line with the international timetable.

The minimum leverage ratio should be comparable with Australia’s global peers. In the Inquiry’s view, an appropriate range is likely to be 3–5 per cent, calculated in accordance with the Basel framework.

Objectives

Limit systemic risk and the potential for shocks to be transmitted through the financial system.

Retain the risk sensitivity of capital requirements, while providing a mechanism that accounts for limitations and risks in modelling risk weights.

Maintain investor confidence in the strength of Australian banks.

Problem the recommendation seeks to address

Leverage is a useful and necessary part of the banking system. It allows a bank to take savers’ funds — whether in the form of deposits or creditors lending to the bank — and channel them to borrowers to fund investment in the economy. However, leverage also introduces risks. A highly leveraged institution has smaller buffers available to absorb loss before insolvency. Leverage can also amplify the effect of shocks on an institution’s balance sheet. This may spread shocks to other institutions and cause systemic risks.

A number of countries have introduced leverage ratios, including the United States, the United Kingdom and Canada. Australia does not currently have a minimum leverage ratio requirement, although APRA has indicated that it may introduce one in line with the Basel framework. Details of how this would operate are being reviewed internationally.

Currently in Australia, restrictions on leverage are achieved indirectly by ensuring ADIs use capital funding in proportion with risk. In the Inquiry’s view, the practice of relating capital requirements to risk is appropriate.

However, there are concerns that, in some instances, the risk-weighted approach may lead to insufficient levels of capital.71 This danger is possible under the standardised or IRB approach, but is greatest for IRB models, as there is potential for ‘model risk’. For example, if the historical data are too benign, the models that underlie the risk-weighting system may underestimate the true risk, leading to inappropriately low levels of capital.72 Concerns have also been raised that banks may have the capacity —and incentive — to manipulate IRB models to achieve a lower capital requirement.

Studies have revealed substantial variation among IRB risk-weight models across countries.73 Although this does not suggest IRB models are unsuitable, it does give reason to be cautious about their outputs.

A number of ADIs support having capital requirements commensurate with risk, meaning that capital requirements should generally be determined by the risk-weighted capital ratio. Similarly, APRA supports the principle of aligning capital with risk, being the primary driver of bank capital positions.

Both options would introduce monitoring and reporting costs for ADIs, although these are not expected to be large. As a backstop, the leverage ratio would not generally require ADIs to change their level of capital.

Conclusion

Whether a leverage ratio is a binding constraint or a backstop to the risk-weighted approach, the benefits are similar. Both options discourage excessive leverage and protect against risk being substantially underestimated, leading to weaker capital positions. However, the costs and risks will be greater with a binding constraint.

In the Inquiry’s view, having a leverage ratio as a meaningful backstop provides appropriate insurance against the risks inherent in risk-based capital requirements, while retaining the advantages of having capital requirements commensurate with risk.